Real estate investment trusts (REITs) are companies that hold a portfolio of real estate properties. Most REITs manage the properties they own. REITs can be an excellent investment in a diversified portfolio, offering an income stream higher than many other types of investments. Interested in REIT investing? Here’s a guide.

What REITs Are

It’s important to note that, while REITs own real estate, they do not own them with an eye to reselling or developing property. REITs are focused on managing income-producing properties. They purchase and hold properties with an eye to their income potential.

Most REITs specialize in a type of real estate. The types include commercial (retail spaces and malls), residential (apartment complexes), healthcare (hospitals) and industrial (warehouses and storage space).

REITs as an Investment

Publicly traded REITs offer several significant advantages to investors.

First, they have a high dividend yield. REITs are required by law to pay out at least 90 percent of their income stream to investors. Many pay out more, up to 100 percent. As a result, investors in REITs can enjoy dividend payouts above what they would find in other types of investments. Over the past two decades, REITs have returned an average of nearly 12 percent to investors. The Standard & Poor’s 500, a broad index of stocks, has returned an average of over 8 percent.

Second, publicly traded REITs offer transparency. They are traded on stock exchanges, just as stocks are. As a result, their financial reporting requirements are public and can be easily accessed by investors. Buying physical real estate individually as an investment requires significant research into the condition of the property and real estate conditions that can affect the investment. With REITs, that research is performed by the REIT and made public.

Third, because publicly traded REITs are traded on stock exchanges, they are convenient both to purchase and to sell. They can be bought and sold just as stocks can be. Buying physical real estate is a lengthy process, requiring mortgage applications and financial disclosure for the investor. Buying shares in a REIT can be nearly immediate — as fast as the purchase takes to complete.

Similarly, if an investor ever wants to sell shares of a REIT, it can be done immediately. Physical real estate is not a liquid investment for those who purchase the properties. It can take a long period of time to sell property, and showing it to potential buyers takes time and effort. REITs are liquid.

Non-Traded REITs

Investors should know that non-traded REITs are a category. They operate as public REITs do, but are not traded on public stock exchanges. Investors need to go through a broker who specializes in non-traded REITs.

Investment Considerations

Taxes

REITs come with the same investment considerations that other stocks do regarding taxes. investors should remember that dividends are taxed, and be prepared to pay the tax annually.

In addition, REITs can appreciate in price in addition to the dividend, just as stocks do. If the REIT price rises, it may declare a capital gain. If so, investors will need to pay the capital gains tax.

Market Conditions

They also come with some of the same investment considerations as real estate. Real estate conditions can vary. Real estate markets can be hot, with very low vacancy rates. These allow REITs to charge optimum prices for the real estate they hold and manage. But, of course, real estate markets can also be poor, with high vacancy rates. If this occurs, prices will be low. Or, real estate markets can be average, with good but not spectacular prices.

Market conditions depend on the economy and the direction of interest rates, to some degree. A strong economy generally will lead to a strong real estate market, as company profits allow them to expand. A weak or softening economy will eventually cause real estate markets to decline, because companies retrench.

Lower interest rates make mortgages more favorable for companies. They can buy more property with the money they have. As a result, lower interest rates often cause companies to expand as well. Rising interest rates make mortgages more expensive. A climate of climbing rates can make companies reluctant to expand. It can also delay existing plans if ground has not been broken.

REIT investors should keep careful watch on economic conditions in the areas REITs are invested in. They should also keep up with the direction of interest rates. If either of these changes in a way that could affect the price of the real estate the REITs hold, investors may want to consider selling the REIT.

Portfolio Diversification

Diversification means holding different types of asset classes in one’s portfolio: stocks, bonds, real estate and cash. The advantage of diversification is that it allows investors to benefit from the upside of their chosen investments, but it protects against the downside risk of having all the portfolio eggs in one basket. If the stock market falls, for example, diversified investors can still benefit from real estate, bonds and cash. If bonds tank, diversified investors will still have stocks, real estate and cash.

While REITs can be a great investment, real estate values go both up and down. If profits go up, all is well if you’ve chosen a well-managed REIT. But if profits fall, REIT dividends may be 90 percent of a smaller pie, so they will fall as well. Many investment advisers recommend holding no more than 5 percent to 10 percent of a portfolio in REITs, so if real estate markets are adversely affected, your portfolio is protected.

REITs hold and manage commercial real estate property. They can be great investments because they offer high dividends, transparency, convenience of buying and selling and liquidity. Investors interested in REITs should research the real estate market in which they operate and keep up with economic conditions and the direction of interest rates.